On the Integration of Financial Management and Strategic Management'
Benjamin M. Oviatt, Oklahoma State University
ABSTRACT
This theoretical exploration answers some questions
posed by Bettis (1983) in his examination of the inter-
face between financial and strategic management. The
integration of the two disciplines is extended through
the introduction of transaction and agency cost theory.
The implications of the theory for managerial and
shareholder motivation are discussed, and the conclu-
sion is drawn that managerial and shareholder interests
may be more congruent than strategic management has
acknowledged, but less congruent than financial theo-
rists have assumed.
INTRODUCTION
Bettis (1983) called attention to the neglected inter-
face between modern finance and strategic management.
While his aim of incorporating financial theory into
the strategic management literature was worthy, the
three conundrums he delineated may be less puzzling
than he believed. The purpose of this paper is to
solve two of the conundrums, briefly suggest an alter-
native framework for investigating the third, and to
extend Bettis' (1983) quest for an integration of the
disciplines of financial and strategic management.
THREE CONUNDRUMS
1. Unsystematic Risk Management
Bettis (1983) provided a selective and sufficient re-
view of two important ideas in the finance literature:
the capital asset pricing model (CAPM) and efficient
capital markets. The review will not be repeated here.
Readers wishing a thorough analysis may consult
Copeland and Weston (1983).
Building on Salter and Weinhold (1979), Bettis (1983)
noted an implication of the CAPM is that corporation
managers should be concerned with systematic risks, not
unsystematic risks. Yet, the strategic management
literature has demonstrated the necessity for managers
to address those unsystematic risks, as well. Bettis
was puzzled why strategic management and the CAPM had
conflicting foci and stated a conundrum which he said
needed a solution:
Modern financial theory suggests that the
equity markets will not reward unsystematic
(i.e., firm specific) risk management, but
unsystematic risk management lies at the
heart of strategic management, (p. 406)
Peavy (1984) solved Bettis' (1983) conundrum by showing
mathematically that the CAPM does not ignore unsystem-
iThe author wishes to thank Professor R. Dennis
Middlemist of Oklahoma State University for a valuable
review of an earlier draft. Professors Alan
Bauerschmidt and Philip Cooley both of the University
of South Carolina for contributions to the development
of this paper, and anonymous reviewers for useful
suggestions.
27
atic risk. While not ignoring such risk, it is clear
that the financial literature has emphasized systematic
risk in researching the implications of the CAPM (e.g.,
Myers, 1977). This emphasis is essential to satisfy
corporate shareholders, and the CAFM assumes that the
maximization of shareholder utility (wealth) is the
single goal of corporate managers.
Bettis (1983) concluded that the strategic management
literature, however, deals with a variety of goals and
nonmaximizing behavior. Yet, he did not recognize the
significance of this conclusion; that is, goal variety
necessitates the consideration not only of systematic
risk, but also of unsystematic risk. Thus, Bettis'
first conundrum can be solved by recognizing that the
differing assumptions of the CAPM and strategic manage-
ment concerning managerial goals lead directly to em-
phases on different components of risk.
2. Information Disclosure
Information about firms is valuable to investors in
making forecasts of firm performance. Investors will
pay a premium for the reduction in uncertainty that
relevant information provides. Managers can, there-
fore, increase the value of their firms, ceteris pari-
bus, by disclosing all the information possible that
will help investors be more certain of predictions of
superior performance. Bettis (1983) argued that such
conclusions are primarily a product of the efficient
market theories of modern finance.
Bettis (1983) also noted that the disclosure of that,
same information (e.g^, production secrets) may be
valuable to competitors in defeating the firm in the
marketplace for its products. Bettis' conundrum was:
Modern financial theory suggests that
disclosing additional information about a
project or strategy can positively affect the
value of the firm, but strategic management
has stressed only the value of such informa-
tion to a firm's competitors, (p. 406)
Bettis (1983) implied in the conundrum that the two
disciplines offer conflicting advice on the disclosure
of information about corporate activities. But he
seemed to recognize later that the real problem is the
calculus of the conflicting creative and destructive
values of information:
At some point, information disclosure will
start to inhibit entrepreneurial and innova-
tive behavior to an extent not justified by'
the Improvement in investor forecasts. Re-
search is needed to establish the location of
this point, (p. 410)
It seems unlikely that the disciplines would offer
conflicting advice on the matter—Bettis (1983) cited
none. Unless Bettis intended that the conundrum is the
calculus problem with possibly unmeasurable variables,
the conundrum on information disclosure does not exist
(c.f. Peavy, 1984).
3. Global Competition
In international competition, some firms
outside the United States are demonstrably
willing and able to accept returns that are
below those necessary in the environment pos-
ited by modern financial theory, but others
are not. Strategies and public policies for
dealing with such asymmetries need to be de-
veloped, (p. 406)
On this conundrum, Bettis (1983) and the current author
achieved some agreement. Bettis recognized as false
the assumption that the goal of eill the competitors in
a global market is to maximize shareholder wealth.
What Bettis did not state directly is that the CAPM is
an inappropriate model of a global product market.
While resisting the temptation to delve into a subject
tangential to this paper, it is suggested that cost-
benefit analysis might be a superior framework for the
analysis of global product markets. The benefits
(e.g., employment, protection of natural resources,
market dominance) that some nations seek from global
markets are sometimes paid for by lower financial re-
turns on the sale of their corporate exports.
TOWARD AN INTEGRATING THEORY
Although insight into two of the conundrums was
achieved by recognizing that strategic management and
the CAPM make different assumptions about the motiva-
tion of managers, highlighting such differences does
little to extend Bettis' (1983) quest for an integra-
tion of the disciplines. In support of this quest, the
remainder of this paper explores recent developments in
financial theory, organization theory, and strategic
management that have an integrating potential so great
that Ouchi (1977) suggested the possibility of a "uni-
fied social science. . .during our lifetime." Agency
cost theory (Fama, 1980; Jensen and Meckling, 1976),
from the discipline of financial management, and
transaction cost theory, given birth by economists
(Williamson, 1970; 1975), nurtured by organization
theorists (Astley and Van de Ven, 1983; Ouchi, 1980),
and as yet a gleam in the eye of strategic management
scholars (Lenz, 1981; Porter, 1981; Rumelt, 1982;
Wrigley, 1979), will be shown to be compatible frame-
works with strong conclusions about managerial motiva-
tion and with the ability to integrate academic disci-
plines.
Agency Cost Theory
Extending the work of Coase (1937) and Alchian and
Demsetz (1972), Jensen and Meckling defined organiza-
tions as "legal fictions which serve as a nexus for a
set of contracting relationships among individuals"
(1976, p. 310). They noted that such a definition
established a firm as a complex process in which the
conflicting objectives of individuals within the nexus
could be brought into equilibrium by the framework of
contractual relations. These financial scholars high-
lighted the conflicting objectives of managers and
shareholders, and concluded that each was maximizing
her own utility. Characterizing the shareholder as a
principal and the manager as her agent, Jensen and
Meckling (1976) made an extensive analysis of the prob-
lems and costs (known as agency problems and agency
costs) of maintaining mutually satisfactory behavior on
the part of the principal and the agent within the
nexus of contracts that is the organization.
Fama (1980) extended this line of thought. He
conceptualized the manager and capital suppliers (both
debt and equity) of the modern large corporation as
separate factors of production, each motivated by their
28
own self interest. The manager's main role was seen as
a contract coordinator for the nexus of shareholders,
employees, customers, suppliers, managers, and other
contractors. Two important implications for Fama
(1980) were (1) no one—including equity suppliers—
really owned the modern large corporation, and (2)
entrepreneurs did not really exist in such a structure.
Agency cost theory makes no assumption that managers
maximize shareholder utility, and it has a power to
explain conditions of interest in financial management
which have been intractable for some time (e.g., capi-
tal structure). The idea now seems to be part of the
mainstream of theory building and theory testing in the
financial management literature (Barnea, Haugen, and
Senbet, 1981; Copeland and Weston, 1983; Weston,
1981).
Transaction Cost Theory
The theory of agency cost can be seen as a subdivision
of the broader framework of transaction cost theory (De
Alessi, 1983). A transaction is an exchange of a good
or service across a technologically separable inter-
face, and it is the basic unit of organizational analy-
sis in the theory (Williamson, 1981; Williamson and
Ouchi, 1981). A major objective of every party to a
transaction is to have an efficient (least cost) ex-
change. As Ouchi (1980) summarized the transaction
cost perspective:
An organization, in our sense, is any stable
pattern of transactions between individuals
or aggregations of individuals. Our frame-
work can thus be applied to the analysis of
relationships between individuals or between
subunits within a corporation, or to transac-
tions between firms in an economy, (p. 140)
The perspective assumes that the parties to an exchange
are (1) intendedly, but boundedly rational (Simon,
1976; 1978; Williamson, 1981), and (2) sometimes are
given to opportunism, or are untrustworthy (Williamson,
1981). Thus, the individuals in an organization, in-
cluding the managers, are promoting their own interests
to the best of their ability, and these interests may,
or may not, coincide with shareholder utility.
The most important properties of transactions are (1)
the degree of uncertainty in the outcome, (2) the
frequency with which transactions recur, and (3) the
degree to which durable, transaction specific invest-
ments are required to achieve least cost supply
(Williamson, 1981). These properties determine the
types of contracts which develop between the parties to
the transactions. A classical spot market contract
will govern the transaction if the outcome is easily
and quickly measured, the transaction does not continu-
ously recur, and the assets involved are not unique to
the transaction.
The retail sale of beer would be an example of this
type of contract between the customer and the liquor
store. An example of the opposite of the conditions
listed above would be the employment contract of the
manager of the liquor store. The store owner is uncer-
tain of the exact work activities and outcomes that
will be required at all times, and must rely on the
manager's judgment in many circumstances. The employ-
ment relationship is a continuous one. The manager
possesses skills that are specific to the management of
the owner's liquor store, and those skills would be
costly for the store owner to replace should there be a
turnover of managers.
A major implication of transaction cost theory is that
a norm of efficiency will dictate an organization's
boundaries and at least some of its strategic actions,
such as the degree of vertical integration (Williamson,
1975). Market type contracting will yield to internal
organizational contracting as the transaction costs of
obtaining relevant information, adjusting to change,
monitoring the parties to the exchange, and harmonizing
the interface rise. Thus, the boundary between the
organization and its customers, suppliers, and competi-
tors is drawn (Williamson, 1981).
Although the implications of transaction cost theory
for the study of organizations are rich, the limited
objective here is to explore its potential for the in-
tegration of modern financial theory and strategic man-
agement . Other facets of the theory are examined in
the works of Williamson and Ouchi listed in the
References of this paper.
INCENTIVES FOR CONGRUENT MANAGER AND
SHAREHOLDER INTERESTS
The contrary assumptions of the CAPM and strategic
management, regarding managerial motivation, contrib-
uted to two of Bettis' (1983) conundrums. But, finan-
cial management and strategic management may be able to
achieve some agreement about managerial motivation
within the framework of transaction cost theory (and
its subset agency cost theory). Williamson (1970),
Jensen and Meckling (1976), and Fama (1980) were in
agreement that managers are motivated by their own self
interest. Yet, together they exposed a surprising
number of incentives that tend to make managers' and
shareholders' interests congruent. Furthermore, the
logic of these authors might satisfy the emphasis of
strategic management on descriptive goals (Bettis,
1983).
Incentives Within the Multidivisional Structure
0. E. Williams' writings on the superiority of the
multidivisional form (M-form) of organizational struc-
ture to the unitary, or functional, form (U-form) first
brought his ideas to the attention of organization
theorists and strategic management scholars (e.g.,
Williamson, 1975; 1970). In the M-form of semiautono-
mous businesses, the performance of divisions is mea-
sured almost entirely by economic criteria such as ROI.
In addition, a closer monitoring and understanding of
divisional performance is allowed in the M-form due to
the great amount of information available to corporate
executives, tbe familiarity of those executives with
the corporation's portfolio of businesses, and the
close supervision by the expert corporate staff. Thus,
Williamson (1975; 1970) hypothesized managerial
emoluments were attenuated and shareholder interests
(efficiency of resource use) were emphasized in the
M-form as compared to the U-form. This hypothesis has
received moderate empirical support (Armour and Teece,
1978). Williamson (1970) expressed his view that
profit maximizing behavior may be much more closely
approximated than the critics of the neoclassical
theory of the firm have believed, since the M-form has
been widely adopted by the large manufacturing firms in
many U.S. industries (Rumelt, 1974).
Capital Market Incentives
Jensen and Meckling (1976) ignored organization
structure and stressed that owner-managers (a focus
most appropriate in small to medium size firms) who re-
duce organizational profits by increasing expenditures
on perquisites will pay for this behavior when they
seek outside financing. The authors assumed that the
suppliers of outside capital have information that en-
ables them to develop unbiased estimates of the cost of
managerial perks, and that the errors in the estimates
29
are independent across the large number of firms in the
market for outside financing. Thus, when the owner-
manager seeks such financing, the price she receives
for bonds or equities is lowered by (1) the expected
value of managerial perks, (2) the expected cost to
capital suppliers of any business decisions which bene-
fit the owner-manager and not the capital suppliers,
and (3) the expected costs to capital suppliers of mon-
itoring owner-manager behavior. The major point here
is that relatively efficient capital markets provide an
incentive for owner-managers to consider the interests
of capital suppliers, else owner-managers will pay for
their failure to do so when they sell claims on the
firms' cash flow to outsiders.
It has been noted that this form of incentive for
managers is weakened by the fact that firms use equity
markets infrequently (Ellsworth, 1983; Williamson,
1970). Thus, the incentive may only be intermittent.
Managerial Labor Market Incentives
Fama (1980) uses the managerial job market in
conjunction with the capital markets to generalize the
Jensen and Meckling (1976) approach to large corpora-
tions. According to Fama (1980) if managers act to
siphon off resources for their own benefit or act in
other ways that fail to maximize firm value, their
behavior will be reflected in depressed prices for
their firms' shares and bonds. Stock and bond price
fluctuations serve as signals of managerial effective-
ness to the managerial labor markets. Those signals
are used by boards of directors to determine managers'
compensation. Therefore, the capital and labor markets
operate together to influence compensation so that the
manager is rewarded or penalized for her ability or in-
ability to increase shareholder wealth.
Of course, much information about managerial
performance is hidden in the complex causality that
determines any organizational outcome—including stock
price. Yet, that very uncertainty should bias manager-
ial compensation down if directors are averse to re-
warding behavior which is of uncertain benefit. Thus,
competent managers have an incentive to make the clear-
est possible association between their performance and
the price of their firm's stock.
The Incentive of Intra-firm Managerial Competition
Fama (1980) also recognized that top managers were
disciplined by other managers in the firm, especially
those near the top. Such managers want to provide as
many positive' signals as possible to markets for their
labor, and are aware that their performance is partial-
ly signaled by their firm's stock price. Therefore,
managers near the top tend to support only competent
top managers who are perceived to be raising the firm's
stock price. In this way the hierarchy of managers may
provide another incentive for managerial behavior which
coincides with stockholder interests.
Director Incentives
Fama (1980) hypothesized that outside directors were
especially useful in stimulating and overseeing the
competition between managers within the firm, and
insuring that such competition contributes to stock
price increases. Fama (1980) believed the discipline
of the market for the services of outside directors
would insure that directors provide this stimulation
and monitoring. However, Fama (1980) recognized the
typical weakness of boards of directors (Mace, 1971;
Monsen and Downs, 1965) by putting less emphasis on
this form of discipline than on the managerial labor
market.
Takeover Threat Incentives
Both Williamson (1970) and Fama (1980) recognized that
acquisition threats by outside firms may be an incen-
tive for managers to maintain a high stock price. But
both also warned against the power of such a threat,
except in extreme circumstances, because of the great
cost and uncertainty of a takeover effort that must be
assumed by an acquiring firm.
Stock Options Incentives
Stock options have been viewed as powerful incentives
for managers to increase stock price for some time
(Lewellen, 1969). But again, the issue of the complex
causality of organizational outcomes makes any
connection between managerial behavior and stock price
difficult to observe (Williamson, 1970). Thus, the
incentive is weakened.
Incentives for Shareholders
The list of incentives has so far included only those
impinging on managers. Yet, shareholders are also
inhibited from making excessive demands on organiza-
tions. The nexus of contracts that constitutes an
organization is a team of interdependent individuals
(Ouchi, 1980). The individuals' shares of the total
organizational inputs are difficult to measure in many
circumstances, and the team's outputs are more than the
sum of individual inputs (Alchian and Demsetz, 1972;
Ouchi, 1980). Because of measurement problems, moni-
toring costs (a type of transaction cost) are incurred
by team members to insure that the returns generated by
the organization are equitably distributed among team
members (Ouchi, 1980). No member (shareholder, man-
ager, employee, etc.) can long enjoy recognized dispro-
portionate returns without incurring the costs of
inferior inputs by the dissatisfied members of the team
(Sherwin, 1983). Thus, it is self serving for each
member to insure that all other members achieve some
minimum level of satisfaction (Cyert and March, 1963).
Shareholders who insist on the superiority of their
claims to organizational rewards may disturb the team's
efficient functioning.
CONCLUSION
The list of incentives that may cause manager and
stockholder interests to coincide is a long one. Al-
though each incentive was seen as limited by counter-
vailing forces, the sheer length of the list is impres-
sive. Even if the incentives are weak, or apply only
intermittently, their collective force may be strong.
These implications of transaction cost theory and
agency cost theory suggest that there may be a greater
congruency in managerial and shareholder interests than
strategic management has generally acknowledged, but
less congruency than some financial theories (e.g.,
CAPM) have assumed.
The question of the degree of congruency is not a new
one (Berle and Means, 1932), and a variety of factors
may foster incongruent managerial and shareholder
interests (Baumol, 1977). But transaction cost theory
may suggest a new framework for investigation. The
answers to newly framed questions may provide new in-
sights, and several new questions are apparent from the
preceding review of managerial and stockholder incen-
tives . What are the specific transaction costs in-
volved in the shareholder-manager relationship? Do the
incentives for congruency in the relationship reduce
those transaction costs? Which incentives are most
powerful and involve the least transaction costs?
30
On another level, what is the integrating potential of
transaction cost theory? Can the theory provide a
solid framework for advancing Bettis' (1983) desire to
integrate financial management and strategic manage-
ment? Even more important, how close can transaction
cost theory take us to Ouchi's (1977) vision of a uni-
fied social science? The list of relevant questions
could be expanded, and it seems likely that the trans-
actions framework provides an interdisciplinary oppor-
tunity to advance our understanding of organizations.
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